The conclusion of 2023 witnessed a common theme for global equity markets, wherein the path of higher interest rates exerted a deleterious impact on equity valuations. However, the shift in market sentiment, now pricing in a meaningful monetary easing in 1HCY24, offered support for Price to Earnings ratios. Investors are embracing the evidence from a more stable momentum in moderating inflation trend and showing increasing appetite for risk assets.
The rally observed in November across global equity markets sustained its momentum into December, marking a persistent global upswing, notably pronounced in Australia. The ASX 200 displayed remarkable strength for the second consecutive month, posting a monthly return of 7.3%, taking the total return for the ASX 200 accumulation index to 12.4%.
We have had cause to reflect on 2023 – what perspective the year can bring, and what we can bring to a rejuvenated effort in 2024. Below are some of our key takeaways.
Goldilocks Temptations. It is tempting for investors to predict a ‘Goldilocks’ or ‘ideal state economic conditions’ scenario and act with a corresponding optimism. We witnessed this in January 2023, the strongest start in over 3 decades, as the market welcomed in a warm porridge of improved global macroeconomic data. We witnessed this again mid-year, after the US Federal Reserve decided to pause the hike. At the end of the year, we saw the sentiment peak as financial markets factored in a predicted end to this rate hike cycle.
Early Rally. The sentiment driving the early market rally in January 2023, pricing in the end of the rate hike cycle in 1Q23 and even a potential cut from September 2023, proved to be at least a year early.
Persistent Inflation. Inflation in Australia has persisted, especially relative to the US market. Interest rate rises have taken longer than anticipated to mitigate either inflation or consumer demand.
Unexpected Resilience. We entered 2023 conservatively, anticipating tighter financial conditions and a higher cost of capital to weigh on corporate margins. Instead, what transpired was a more benign outcome. The economy has remained resilient, bolstered by strong employment and migration.
Portfolio Positioning. Our conservative positioning translated to overweighting in Health Care and Consumer Staples, and underweighting in the Consumer Discretionary sector. This negatively impacted our performance. However, our conviction for seeking and sustaining investment in high-quality businesses such as James Hardie, Goodman Group, and Premier Investments fared more favourably towards our overall portfolio return.
Balance sheet. One of the biggest surprises to analysts during full year reporting season in 2023 was the much higher than estimated interest expenses reported by ASX 200. We have seen how this can erode companies’ earnings despite strong revenue growth and sound Earnings Before Interest and Tax margin. As such, we have significantly reduced the overall gearing of our portfolios by divesting companies with higher relative debt levels. An example of this is the portfolio’s divestment of Healius in August due to its balance sheet deterioration. The stock price has fallen ~50% since the divestment at the time of writing.
Earnings Revisions. Analysts’ ASX 200 earnings revision went from a negligible +0.1% post February reporting season to -2.6% post August reporting season, with August 2023 reporting season ranking as the 44th out of 46 going back to February 2001.
2024 Outlook. The immediate risk for inflation and interest rates has eased over the last month, heralding in a level of cautious optimism by equity investors. Nevertheless, the pathway forward will require careful navigation, particularly if inflation remains stubborn ensuring that interest rates stay higher for longer.
All things considered, a vigilance on earnings resilience and balance sheet strength continues to be an essential attribute to portfolio construction.
We've provided a month-by-month timeline detailing the ASX 200 performance from January to December 2023. The following snapshots summarise our observations and contextualise our key takeaways from each month of 2023.
ASX 200 chart
Entering 2023, the landscape was shaped by heightened inflation and rising bond yields, leading to a contraction in Price to Earnings Ratios (PER) globally and domestically. NASDAQ PER contracted from 32X to 23X and ASX 200 from 18X to 14X in 2022.
A notable shift occurred at the beginning of 2023, with a resurgence in risk appetite fuelled by favourable global macroeconomic data. This economic upturn eased financial conditions, fostering expectations of reaching peak inflation and a more gradual pace of interest rate increases.
The market was optimistic, pricing a goldilocks scenario with a ‘soft landing’ for the global economy. ASX 200 PER quickly went up to 15.5X.
The market rally cooled. Australian corporates reported healthy revenue but weighted down by cost inflation, in particular wage and interest costs. Analysts’ Earnings Per Share (EPS) revision for ASX 200 was at a negligible 0.1%.
The market fell only modestly this month, despite the increased uncertainty brought on by banking stress in the US and Europe. Some investor relief was provided when regulators stepped in to stem contagion risk around uninsured deposits.
The market weathered multiple interest rate rises and so far remained resilient. This was buttressed by low unemployment and a resurgence of migration levels on corporate earnings.
The month of banking sector reporting season revealed a challenging outlook, with the initial benefit of higher interest rates on bank Net Interest Margin being diluted by elevated competition for deposit and mortgage customers. A Resources sector sell-off also contributed to the weaker market as investors exited the initial recovery in commodity prices from China’s reopening.
In contrast, optimism towards the technology sector’s improving growth outlook, especially around the potential benefits of Artificial Intelligence (AI), underpinned the outperformance of growth stocks relative to value stocks over the month.
Earnings expectations for the market continued to be revised lower for FY23. By then, global central banks were raising rates at the fastest rate since the 1990s to tame persistent inflation, and the RBA held cash at 4.1% while flagging the need for further tightening. The ASX 200 valuation metrics were relatively stable, based on a forward PER of 14.5X and a dividend yield of ~4.3%, both of which were trading around their 30-year average.
The ASX 200 continued to rise mid-year, consistent with a sentiment that central banks were then close to the end of tightening, without a hard landing. Cyclical Industrials and Information Technology companies were strong outperformers relative to Quality and Defensive companies.
The July bounce in the ASX 200 pushed valuations above average, with PER trading ~15X. Recent company announcements and an increase in negative earnings revisions suggested Australian companies began to experience a slowdown, as higher interest rates and cost of living pressures weighed on consumers.
The 2023 August reporting season delivered a higher incidence of earnings downgrades. Revenue was steady but more than offset by wage and interest expenses. The FY23 earnings season was hard on companies that had leveraged balance sheets at >3x Net Debt/EBITDA. This was particularly so for companies with more fixed rate debt rolling off into higher rates, for which negative share price reactions were most pronounced.
ASX 200 companies provided cautious guidance for FY24, with the market clearly entering an earnings downgrade cycle. Discretionary, REITs and Energy outperformed and Utilities, Staples, and Tech underperformed.
A renewed ‘hawkish’ stance by the US Federal Reserve unsettled investors. The equity market started to respond negatively to the pressure of higher interest rates while bond yields rose. The goldilocks scenario dimmed with the prospect of another Fed rate hike this year.
Equity investors were rightfully weary at the combination of ASX 200 PER trading at a modest premium to its long-term average, a quickening pace of negative earnings revisions by analysts, and the ASX 200 dividend yield now below the 10-year government bond yield for the first time since 2011.
The ASX continued to fall, pressured by the continued rise in bond yields. At this stage, the higher interest rate environment was yet to dampen either inflation or retail spending in Australia.
This month, the higher bond yields had a deleterious impact on the Technology, Healthcare and Real Estate sectors, while heightened geopolitical tensions in the Middle East fuelled the Energy and Gold sectors.
Global equities rallied in November, buoyed by evidence that inflation was finally moderating to a level that would allow the US Fed to consider stopping raising interest rates and even cutting rates in 2024. After peaking at nearly 5% in October, bond yields also rallied sharply, before subsequently falling to 4.5% by the end of November, much to the relief of equities markets.
The rally observed in November across global equity markets sustained momentum into December, marking a persistent global upswing, notably pronounced in Australia. Market sentiment shifted with lower rates anticipated and a monetary easing in the first half of 2024. On a 12-month horizon, Technology and Discretionary were the strongest performers in 2023. Conversely, the defensive Staples, Utilities, Health, and Telecom sectors were the weakest performers in 2023, with low single-digit returns.